Contributions to qualified retirement plans such as traditional 401(k) plans are made on a pre-tax basis, which removes them from your taxable income and thus reduces the taxes you'll pay for the year.

There are limits to how much you can contribute tax-free to such a plan. For 2020 and 2021, the annual limit is $19,500. Those who are 50 or older can almost always—it's allowed by 98% of plans— make an additional catch-up contribution each year of $6,500. You can even contribute the catch-up when you are 49, provided you will turn 50 before the end of the calendar year.

Key Takeaways

  • Contributions to traditional 401(k)s or other qualified retirement plans are made with pre-tax dollars, and so are deductible from your taxable income.
  • You can contribute up to $19,500 a year to such a plan in 2020 and 2021.
  • Most plans allow an additional $6,500 annual catch-up contribution for those who will be 50 or over by the end of the year in which the contribution is made.
  • You must pay income tax on funds you eventually withdraw from the plan, but your tax rate is typically lower in retirement than it is during your working years.

How 401(k) Contributions Cut Your Taxes

Because plan contributions shrink your taxable income, your taxes for the year should be reduced by the contributed amount multiplied by your marginal tax rate, as per your tax bracket. 

The higher your income, and thus your tax bracket, the greater the tax savings from contributing to a plan. Take, for example, a single earner who makes $208,000 a year and also contributes $5,000 annually to a plan. Their income places them in the 35% tax bracket for 2020.

Their tax savings from the contribution is, therefore, $5,000 multiplied by 35%, or $1,750. The same $5,000 contribution, then, delivers $650 more in tax savings to our high earner than to the $55,000-per-year earner we cited earlier.

Note, however, that if you choose the Roth 401(k) option, if your employer offers it, your contributions do not reduce your taxable income. Instead, your contributions are made with post-tax income. However, at retirement when you withdraw your contributions, you will not owe taxes on these distributions.

Distributions From a 401(k)

Of course, you don't escape paying taxes forever on your 401(k) contributions, only until you withdraw them from the plan. When you do so, you must pay income tax on the withdrawals, or "distributions," at your applicable tax rate at that time. If you withdraw funds when you're younger than 59½, you'll likely pay an early withdrawal penalty of 10% of the amount as well.

However, chances are you'll pay less to withdraw funds from the plan in retirement than you did when you made the contributions. That's because your income (and tax rate) are likely to have dropped by then, compared with your working years.

For example, let's say our high earner retires and begins to withdraw $5,000 a year from their plan to supplement the $75,000 they receive annually from Social Security and other retirement income sources. With an income of $80,000 a year, they'd be in the 25% tax bracket and would pay $1,250 on those plan withdrawals. That's $500 less in tax than the $1,750 they would have paid had they not made the original $5,000 contribution to the plan, and instead paid tax on that money in order to use for other purposes. (In this scenario, they also would not have enjoyed the use of that $500 in the ensuing years, including possibly investing it for still-greater gains.)

Qualified retirement plans require this tax treatment not only of withdrawals but from the original contributions to the account. Any investment income the contributions may have earned in the years between the contribution and its distribution can also be withdrawn, with the same applicable income tax applied to them.

That can help make maximizing your contributions to a retirement account a better investment strategy than directing money to a regular brokerage account. That's because skipping paying tax on your account contributions allows you to have more capital working on your behalf during the years leading up to retirement.

As an example, a person in the 25% tax bracket with 20 years until they retire might either contribute a pre-tax $400 a month to a 401(k) plan or divert the same amount of earnings to a brokerage account. The latter option would yield only a monthly contribution of $300 after paying a 25% tax on the $400 in income. The extra $100 per month from the 401(k) option not only increases contributions but further expands the nest egg by having a larger balance on which earnings can compound over decades.

The difference between the scenarios could amount to tens of thousands over the long run.